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Buying a house is a huge financial obligation. Not only do you likely need to provide a big down payment, but you have to secure a reasonable monthly payment on your mortgage, as well.
Fortunately, those two costs are related — a bigger down payment means a lower monthly payment. To secure that lower monthly payment, some people consider using a 401(k) to buy a home. While you can use retirement funds to fund a down payment, it’s often not advisable.
In this piece, we’ll discuss the process and consequences of using a 401(k) or 403(b) to buy a home. Again, it’s not the best financial move for most people due to the opportunity cost to do so, but if you really want to make a larger down payment, we’ll explain the rules and what you can do to use your 401(k) to buy a home.
For the purposes of this article, we’ll assume you’re under 59½ years old and still employed. (If you aren’t, you may be able to withdraw from your retirement accounts without penalty.)
The 401(k) and 403(b) rules
Retirement accounts like 401(k)s and 403(b)s grow tax-free. In exchange, the government severely limits access to those funds. You are not supposed to withdraw funds from a 401(k) until you turn 59½, or age 55 if you’ve left or lost your job. If you do take the money out before either of these points in time, you’ll incur a 10% early withdrawal penalty on the sum withdrawn. Then, you’ll also owe regular income tax on the amount you withdrew.
Likewise, you must be 59½ or older to make penalty-free withdrawals from a 403(b). If you’ve lost your job, become disabled, encounter financial hardship, or are making a qualified reservist distribution, the IRS may make an early withdrawal exception. Otherwise, you’ll incur the 10% penalty and have to pay income tax on the withdrawal amount.
Roth 403(b) plans aren’t always offered by public entities but you may withdraw contributions from these accounts at any time without penalty as long as the account has been open for five years or more. You may only withdraw your principal contributions, however, and not any earnings without incurring the penalty.
All that said, it’s your money. You’re entitled to it if you’re willing to pay the penalties (or will be able to avoid them).
How to use retirement savings to buy a house
If you really want to use your 401(k) or 403(b) to buy a home, you can do it in two ways.
Get a retirement account loan
The best option for using your retirement savings is to obtain a 401(k) or 403(b) loan. This way, you’ll avoid the 10% penalty and income tax. Additionally, a retirement account loan doesn’t count toward your debt-to-income ratio, and credit bureaus won’t count it — both of which will help you obtain better mortgage terms.
The maximum amount you can withdraw in a 401(k) loan is $50,000. Like other loans, you must pay it back with interest — usually between 1% and 2% — and you cannot contribute additional funds to your 401(k) account until you’ve repaid the loan. That means no employer contribution matches, either, if your employer offers that perk.
Basically, a 401(k) loan freezes your retirement account in exchange for a quick influx of cash. Different employers offer different repayment terms, but generally it’s a maximum of five years. So it could be half a decade until you can actually start growing your 401(k) again.
There are a few important things to note here:
- Not all employers offer 401(k) loans.
- As you repay the loan, you can’t mark these contributions as reductions to your taxable income. In the IRS’s eyes, you’re paying back a loan, not contributing to your retirement.
- If you leave or lose your current job, you’ll still have to repay the loan. Worse yet, should you leave or lose your job, your repayment period shortens, meaning you’ll have to repay the loan in full by the next tax filing date. Failure to repay the loan will make the IRS view it as a 401(k) withdrawal. That means you’ll have to pay the 10% penalty, the income tax on the withdrawal, and still have to pay back the loan.
The bottom line: If you’re not in a very stable place in your career, a 401(k) loan could be a huge problem.
403(b) plans have similar loan rules and restrictions. You can take a loan from a 403(b) plan only if the plan is an annuity and if the plan administrator offers it as an option. A 403(b) plan tax-sheltered annuity can offer loans of up to 50% of the account balance, with a maximum loan amount of $50,000.
The repayment terms for 403(b) plans tend to be kinder, though. Loans normally must be repaid over five years, or even longer if the loan specifically goes towards a home. However, failure to repay the loan on time still results in the IRS viewing it as an early withdrawal.
Retirement account withdrawals
As we noted before, not all plan providers allow 401(k) or 403(b) loans. If they don’t, and you want to use retirement savings for a down payment, you must make a withdrawal.
Fortunately, if you’re using the money to buy a home, you may qualify for a hardship withdrawal. The IRS considers hardship withdrawals one that cover “an immediate and heavy financial need.” Ultimately, your employer decides whether or not a home counts as a hardship withdrawal. You’ll need to present evidence of hardship before the withdrawal is approved.
Even if you can get the withdrawal, you’ll likely still incur the 10% penalty. Buying a principal residence does sometimes count as a special exemption but it’s very hard to qualify for this exemption. All of your assets that could be used to buy a home get factored in. The IRS views retirement savings as a last-ditch resource, so they are unlikely to waive the penalty. Even if they do, you still must pay income tax on the withdrawal.
Alternatives to tapping a 401(k) or 401(b)
If you want to use retirement savings to buy a house, there are a few better alternatives, including one hiding in plain sight.
Unlike 401(k)s, IRAs are retirement accounts that have special provisions for first-time home buyers. (In this case, first-time home buyers are people who haven’t owned a primary residence in the past two years.)
If you have an IRA, you may be able to withdraw up to $10,000 without incurring a penalty. That $10,000 is still subject to income taxes, but you won’t incur a 10% penalty unless you go over that withdrawal amount. That $10,000 may be just enough to get your down payment in a good place.
Some Roth IRA plans allow you to withdraw up to $10,000 tax-free as long as you’re using it for a first-time home purchase.
Before you tap your 401(k) or 403(b), look to your IRA, if you have one.
Another alternative to tapping a retirement account is to examine government-backed loans. FHA loans are designed to make it easier for first-time home buyers to obtain a mortgage with lower down payment options and lower credit score requirements.
FHA loans require a minimum down payment of just 3.5% if your credit score is 580 or higher. If it’s less, you still need only a 10% down payment.
That said, there are some drawbacks to FHA loans. First, your prospective home must be appraised and inspected by FHA-approved personnel. The home must be your primary residence, and you’ll likely have to pay mortgage insurance for the life of the loan. (Or for 11 years if you made at least a 10% down payment.)
Still, FHA loans may make it possible to buy a house without incurring significant penalties from tapping a 401(k) or 403(b).
If you’re an eligible service member, veteran, or spouse of a service member or veteran, you may qualify for a VA loan. VA loans have lower interest rates, flexible terms, and require no down payment, making them a clear alternative to tapping your retirement accounts.
However, you must meet at least one of these criteria to qualify:
- Served more than six years with the National Guard or Reserves or at least 90 days under age 32, with 30 consecutive days.
- Served 90 consecutive days of active service during wartime.
- Served 181 days of active service during peacetime.
- You’re the spouse of a service member who died in the line of duty or as the result of an injury sustained during active service.
- You’re a veteran discharged due to disability.
If you meet one of these requirements, you must obtain a Certificate of Eligibility from the VA to secure a VA loan.
Buying a house is a huge financial commitment. It’s understandable that you’d want to lessen that financial commitment by coming up with a larger down payment. But doing that by withdrawing from your 401(k) or 403(b) could put you in even more of a financial bind. If you’re thinking about tapping your retirement savings, explore other options first, and make absolutely sure that you’ll be able to get your retirement accounts back on track.